7/16/2009 @ 1:20PM

Buy Un-American

How much should you risk on foreign stocks? Probably more than you’re risking now.

How will traumatized American investors respond to the recent global turmoil? With a wave of investment isolationism, predicts Linda Tesar, chairman of the University of Michigan’s economics department. Frank Warnock, a finance professor at the University of Virginia’s business school, expects the opposite.

These experts in foreign investing don’t agree on what Americans will do, but they’re in complete accord about what they should do: Invest more abroad.

Stocks traded outside of the U.S. are worth $14 trillion, or 59% of total value of global shares. (The figures are as of June 30.) Yet the average American has only 11% of his stock holdings abroad. Perhaps these savers rationalize that they will be spending dollars, not euros or yen, at the grocery store. But they are missing an opportunity for better diversification and returns.

In the 35 years through 2005 a stock portfolio that mimicked the weightings of world stock markets would have delivered an 11.2% annual return to a U.S. dollar investor. A purely domestic stock portfolio would have earned only 10.7% annually. That half-point advantage, compounded, turns into a big difference. The worldly investor who put down $100,000 at the outset of the period would have had $4.1 million at its end point, $600,000 more than the homebody.

Even if returns over the next 35 years are destined to be equal, there is a compelling reason to go global: diversification. Adding foreign shares should (on the presumption that foreign bourses don’t move in lockstep with the U.S. market) reduce volatility in a stock portfolio. That has been the historical result. A hypothetical investor who had moved half his stock money abroad in 1970 would have suffered 12% less volatility risk than someone 100% in U.S. stocks.

Smoothing out the bumps is more than a way to get a good night’s sleep. Market experts point out that any given investor has only so much stomach for risk. Cut the risk they have to endure in stocks by diversifying abroad and investors become willing to own a larger portion of this risky asset class–and thus enjoy greater returns over the long term. On average stocks have outperformed long-term Treasury bonds by 4.1 percentage points annually since 1926. It isn’t, of course, foreordained that this phenomenon will continue or that it will work short-term. As FORBES pointed out recently (“The Case for Bonds”), you would have earned more in Treasurys the past two decades than in stocks.

Vanguard Group researcher Christopher Philips also cautions that stock markets in different countries have become more closely correlated over the past decade. If the global synchronicity persists, it will shrink the benefits of venturing abroad.

What about currency fluctuations? Short- term these add to the risk of a foreign stock portfolio for a U.S. investor. Some foreign funds (such as Tweedy Browne Global Value and Longleaf Partners International) limit this hazard by buying currency hedges. However, currency shifts have a way of washing out, says the University of Michigan’s Tesar. In addition, countries with weakening currencies tend to have correspondingly higher nominal returns.

Given the uncertainties, even experts who consider Americans’ international stock holdings to be irrationally skimpy stop short of recommending that everyone align them with global market weightings. The greatest value in going global is reaped from the first 10% of a portfolio that’s put abroad. Cranking up foreign holdings to 20% of a portfolio will add a smaller but still significant portion of excess risk-adjusted returns. After that the benefits diminish rapidly.

Approach the allocation question with a certain humility. “Any idea of an optimal portfolio is based on historical data, and the world changes,” says Warnock, the finance professor. A 20% or 25% share of your stock portfolio seems about right.

The next question is how to divvy up investments among countries and regions. The European market’s share of the world’s equity value is 30%, that of Japan’s long-suffering market is 10% and that of emerging markets roughly another 10%. These shares can change dramatically over time. Japan’s share during the bubble of the late 1980s was 25%.

The numbers don’t mean that you should have 30% of a $1 million equity portfolio in Europe. Rather, the point is that if you have $100,000 in Europe, a $33,000 allocation to emerging economies (the category includes Russia, China, India and Latin America) is a good starting point.

The simplest way to allocate assets is to let a fund manager do it for you, either actively in a traditional mutual fund or passively in an index or exchange-traded fund. Pay attention to costs. A handful of actively managed foreign funds seem to earn their fees. Among them: Vanguard International Explorer, which FORBES awards an A in up markets and a B in down markets, and Harbor International-Inv, which gets a B in up markets and A in down markets.

If you think that striving after market-beating results is a futile task, then buy a passive fund–and get the cheapest one you can find. Among the bargains: Fidelity Spartan International Index (a mutual fund), which charges 0.1% a year, and the Vanguard European etf, which charges 0.11%. The iShares MSCI European Monetary Union etf, with a similar portfolio to the Vanguard etf’s, dings investors for 0.52%.

Some mutual funds, including Vanguard’s FTSE All-World ex-U.S. Index, charge redemption fees if shares are bought and sold within a relatively short period, so don’t think of them as trading vehicles. Exchange-traded funds do not charge redemption fees but will cost you brokerage commissions and bid/ask spreads; they are not suitable for frequent purchases, like monthly contributions to a 401(k).

If your international fund is in a taxable account, you can get back foreign withholding taxes by claiming them as a credit on your tax return; if the fund is in a retirement account, you receive no credit at home or refund abroad, so it might make sense to hold your shares in a taxable account.

Venturing Abroad

Most Americans have more of their assets at home than is good for them. These funds offer low-cost antidotes.

Performance

.

Total Return

.

.

.

Up

Mkt

Down

Mkt

Fund

5-Yr

Ann.

Latest

12-Mo

Assets

5/31/09

($Mil)

Weighted

Avg

P/E

Cost

Drag

Per $100

.

.

BLDRS Emerging Markets 50 ADR Index

17.3%

-31.1%

$532

10

$0.21e

C

C

Fidelity Spartan Intl Index-Inv

2.3

-30.8

5,461

9

0.11

.

.

iShares MSCI Emerging Mkts Index

14.4

-27.2

30,793

2

0.74

.

.

iShares MSCI EMU Index

2.6

-36.2

654

10

0.54

.

.

iShares MSCI Pacific ex-Japan Index

10.0

-27.3

2,577

11

0.51

.

.

iShares S&P Latin America 40 Index

26.9

-35.1

1,773

13

0.51e

B

B

Vanguard European Stock Index-Inv

2.5

-33.8

13,710

9

0.26

D

C

Vanguard Pacific Stock Index-Inv

1.9

-24.7

7,334

9

0.23

B

C

Vanguard Total Intl Stock Index

3.9

-30.5

20,247

9

0.35

Performance through June 30. Cost drag: annual expense ratio plus brokerage commissions paid by the fund for buying and